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Monday, 30 March 2020

On Dinosaurs and Dividends

Mass Extinction
Sixty-six million years ago an asteroid blew its way through the Earth’s atmosphere and detonated in what we now know as the Yucatan Peninsula in the Gulf of Mexico. The result was a mass extinction event which wiped out about 75% of the world’s species including all of the flightless dinosaurs. As Black Swans go, it was a biggie.

Right now investors are experiencing their own version of the K-Pg event, with whole countries going into lockdown as homo sapiens once more shows its surprising capacity to act collectively when faced with real and present danger. As a side effect investors are discovering that dividends are rapidly becoming an endangered species; but there again – does it matter?

Stinky Dinosaurs 
Humanity’s never ending need to explain things has been sorely tested by the existence of dinosaur fossils but, as usual, theorizing was utterly uninhibited by the lack of any evidence about the actual cause. Suggestions for their extinction have ranged from them going blind due to cataracts through to becoming too stupid to function and the off the wall idea that they got a taste for their own eggs. And those were only the ideas from the scientists, we haven’t even touched on alien abductions or the charming notion that they farted themselves to death.

The actual reason, as proposed by Luis and Walter Alvarez in their paper Extraterrestrial Causes for the Cretaceous-Tertiary Extinction, was almost certainly an asteroid impact. Initially, this wasn’t universally accepted due in part to the conspicuous absence of any obviously large craters and, let’s face it, the idea of flatulent dinosaurs blindly wandering around eating their own young is much more enticing. However, as is the way of science, by a chain of happy coincidence the existence of the Chicxulub crater was eventually established to the point where we can now be fairly certain it was the site of the extinction event impact.

Discontinuity
The idea of a sudden discontinuity is one that many investors will be uncomfortably experiencing right now. If it’s your first time then commiserations – although if you stick at the stock investing game it won’t be your last. The coronavirus sweeping across the world – as I write this I’m in lockdown in the UK – has had a whole host of unexpected consequences including the wholesale cancellation or suspension of dividends by companies facing significant earnings shortfalls.

In fact “shortfall” doesn’t really do this justice. In some sectors – particularly leisure, hospitality and transit – earnings have completely collapsed and companies are dependent on government life support for survival. These are not normal times, and investors have reacted in the time honoured fashion by calmly watching the virus spread for a couple of months and then panicking furiously when they noticed that it doesn’t seem to be paying any attention to central bank intervention. Who’d have thought?

Disaster Myopia
What seems to be stressing private investors – other than the fact that 30% of their portfolios has evaporated like ice in a microwave – is that all of their models for valuing stocks have failed. But any model which relies on historical data to make forecasts – which is to say, all of them – will always fail when a market discontinuity occurs. In stockmarket terms asteroids strike every decade or so and, every time, investors act like it’s never happened before and it’s the end of the world. In cognitive bias terms we know it as Disaster Myopia.

The quasi-religious adherence to models whether they’re based on mining historical data, reading runes off charts or some other econometric analysis virtually guarantees a serious crisis for investors at some point. The history doesn’t show us what’s going to happen, only what did happen. Had circumstances been otherwise something else would have happened – either that or we’re into a belief in pre-determinism, which is a whole different philosophical ballgame.

Sputnik, Panic!
Of course, if you look for the right evidence this isn't a surprise at all. Consider the research from Arnaud Mehl on Large Volatility Shocks - he takes in 126 years of surprises and identifies 43 major shocks - that's one every three years, folks. This covers everything from the Spanish-American War of 1898 through Germany's seizure of Austria in 1938 to Russia's launch of Sputnik in 1957 (yes, really) and beyond. On average these crises triggered a 23% fall in global stockmarkets in the month after the event.

All of these models fail at the exact point we need them most – but because people need to believe that they can predict the future they happily spend their days fitting their models to the data and convincing themselves they’ve found the secret to investment outperformance. Well, current events tell us that they haven’t yet – we have never seen wholesale dividend cancellations like we’re seeing now. Try sticking that in your models.

Dumb Dividends
In fact, this might be a salutary lesson to investors that focusing on dividends is a pretty dumb way of investing. What matters for corporations is their earnings and their ability to grow them, not how much they throw off by way of direct income to shareholders. If by retaining the capital they can reinvest it and grow earnings even more then total shareholder return – share price appreciation and dividends – will be enhanced.

Giving me dividends to reinvest merely makes it more likely that I’ll do something stupid with them, I’d far rather the company kept it and used its expertise to do something constructive. They're experts at their business, I'm an amateur investor - who's likely to make better decisions? Of course, that means an element of trust in the managers – but if you don’t trust the managers then you have bigger problems than the odd dividend, your whole capital is at risk. If you need income sell some stock. Oh, and, by the way, as an investor your job is to figure out whether management are any good or not.

As for dividend cutting corporations – well, they need to be looked at carefully. Construction and non-food retail are being particularly badly hit but there are outliers as well. Managements who’ve just lost significant proportions of their revenue streams are rightly being cautious and any company cancelling its dividends needs to be looked at closely to make sure it’s not looking at an extinction event. Companies with strong balance sheets will weather the storm – although those that have weakened them with option enhancing share buybacks at a premium to intrinsic value may find shareholder support hard to come by if they need cash in a hurry.

Adapt or Die
The aftermath of the K-Pg extinction event is salutary. Life didn’t end, but big land-dwelling dinosaurs were unable to survive in a vastly changed environment. Nimble competitors sprang up to replace them and we saw an explosion of new species. Those who could adapt survived, those who couldn’t did not. Our main job is to figure out who the latter will be, the survivors will take care of themselves in good time.

Meanwhile, stocks in sectors not directly impacted are on sale. Great growth stocks that everyone was clamouring for a month ago are now available at 20%+ discounts. At the moment no one knows where the market will bottom or when and a recession into 2021 now looks nigh on inevitable - but a good company remains a good company as long as the demand for its services remains unchallenged.

However, some behaviour will be permanently impacted – lots of companies may decide that they can manage homeworking just fine and their offices are surplus to requirements, and that it isn’t really necessary for staff to fly all over the place when we have perfectly good video conferencing equipment. Governments and companies will need to think hard about fragile, extended supply chains and healthcare systems will surely be targeted for improvement.

The Marsupials Shall Inherit
In short, the future won’t look exactly like the past. If you take a five year view it’s probably possible to pick some of the survivors out of this mess, but the real success stories are not going to be so obvious. Back at the time of the K-Pg event there was an insignificant marsupial grubbing around for dinosaur leftovers, an animal so insignificant in the scale of things it hardly bore mention. Well, a new thousand mutations later – take a look at us now. Who'd have thought?
 
Find the survivors, ditch those at-risk dinosaurs and look for obvious growth companies in an environment shorn of weaker, price taking competitors. Don't chase growth at any price but do look for snuffling marsupials with an innovative take on the future. The world has not ended, the coronavirus will pass. But do ditch the models and use your brains, that's what they're for.

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